Commodity ETF 2013 Outlook: Global Macro Turning Point?

December 6th at 1:30pm by ETF Securities

Increasing signs of improving global growth and continued strong central bank commitment to highly accommodative monetary policy indicates that the first part of next year has the potential to be a good one for cyclical and risky assets.

In this environment, commodities could perform well as an asset class, with more growth-sensitive commodities such as base metals and the white precious metals having the potential to perform most strongly.

Within equities, basic resources and mining companies could outperform. Commodity currencies such as the Australian, New Zealand and Canadian dollars may rise in this environment and, barring a major sovereign debt-related accident, the Euro should benefit. Conversely, funding currencies such as the Japanese yen and the US dollar may come under pressure.

The three key risks to this benign global scenario are a sharp rebound in sovereign risk in Europe – Greece and Spain in particular; the US fiscal cliff issue and possible US sovereign downgrade; and further political and military deterioration in the Middle East. Long gold, oil and volatility positions are potential hedges against these risks.

Global growth is recovering . . .

As we near the end of 2012 and look into 2013, there are increasing signs that the global economy is starting to recover.

While the recovery is uneven and there are a number of large potential tail risks that can derail it, lead indicators point to an upturn in the global economic cycle. Europe, particularly the periphery, has been left out so far, but the US and China, the two main engines of global growth, are now showing clear signs of recovery.

. . . and developed economy central banks are targeting higher asset prices

At the same time, the world’s major developed economy central banks are committed to maintaining low interest rates and providing extraordinary amounts of liquidity to the world’s financial system.

As the US Fed has made clear in its last two statements, the commitment to low interest rates and the provision of large and regular amounts of liquidity goes beyond short-term crisis prevention policy and will remain in place for a “considerable time” after the economic recovery strengthens.

This stated commitment, together with hints that additional liquidity will be provided in the new year as “operation twist” comes to an end, indicates that the Fed is actively encouraging investors to take more risk and trying to stimulate a sustained rise in asset prices.

Normally, an environment such as this – an upturn in the global economic cycle and highly accommodative monetary policy – would be strongly positive for cyclical and risk assets. However, so far, these types of assets have shown only muted performance, with sporadic sharp rallies often followed by equally sharp corrections.

But high risk of policy mistakes

A likely explanation for why cyclical and risky assets have not performed more strongly is continued investor concern that the positive growth and liquidity environment will be disrupted by policy mistakes – either by the US Congress driving the US economy into a self-induced recession (and ultimately another credit downgrade) by allowing the US to go off the “fiscal cliff” at the end of the year, or gamesmanship by Europe’s politicians leading to a policy mistake that potentially sends Greece out of the Euro and/or invites a renewed sense of panic about the outlook for peripheral European sovereign debt and banking systems.

Until the US fiscal cliff issue is resolved, it is likely that cyclical and risk asset performance will be constrained and remain closely tied to changing perceptions of the likelihood of compromise solutions being found.

Bias towards cyclical assets and key risk hedges

On the assumption that ultimately the fiscal cliff issue is resolved (or at least postponed beyond most investors’ immediate investment horizons) and Europe’s worst problems are kept at bay, the first part of 2013 may be a good one for more cyclically-geared assets.

However, recognizing that US fiscal, European sovereign, and Middle East political risks remain high, it is expected that most investors who increase cyclical weightings will want to maintain a bias towards quality assets and hold hedges against worst case scenarios.

Against this backdrop, how do we see investors positioning themselves for 2013?

Cyclical commodities outperform

In this environment, broad commodity performance should be strong. After underperforming many major equity benchmarks in the latter part of 2012 as global growth faltered, a pick-up in China growth in 2013 should help support commodity prices.

The more cyclical and directly China-demand related commodities will likely perform most strongly. As the chart shows below, historically, the commodities that perform best during global economic upturns tend to be industrial metals, silver, platinum and palladium.

Gold a hedge against worst case sovereign scenarios

Gold may show a positive performance in this environment, as a weaker US dollar supports the gold price. Of course, in this scenario gold will likely underperform the more cyclical metals, as improving growth leads to higher interest rate expectations (and reduced expectations for further quantitative easing), causing periodic bouts of gold price weakness.

Despite the possibility of gold price underperformance of higher beta assets under this scenario, continued low real interest rates, high European sovereign risks, the potential for another US credit downgrade and continued strong central bank buying should keep the gold price well-supported.

If later in the year European sovereign risk concerns rise again (a relatively high probability scenario), the gold price has the potential to rally strongly, as it did last summer when Spain saw its bond yields rise sharply on growing fears it would not be able to finance its debt payments.

Basic resources equities benefit from China recovery

These themes could also play out across equities, with higher beta regions, sectors and themes typically performing well in this environment.

Emerging markets, particularly higher growth regions such as Asia ex-Japan are likely to outperform as global growth expectations rise and the Fed, together with other major developed economy central banks, continue to flood global financial markets with liquidity. Basic resources equities tend to perform well in a rising growth environment, particularly with China’s economy showing signs of cyclical revival.

The low interest rate environment (even if rate expectations do rise modestly) and continued high macro uncertainty would be expected to cause companies with strong cashflows and high dividend payments to continue to attract a premium. As investors increase their weightings of higher beta asset classes and sectors, given the continued large macroeconomic and political risks in 2013, taking tactical long volatility positions may also make sense.

Commodity currencies rally as yen and US dollar fall

2013 should be an interesting year for currencies. If China and US growth continue to recover and commodity prices rebound, commodity currencies will be clear beneficiaries. The Australian, New Zealand and Canadian dollars will likely be some of the biggest beneficiaries of a rebound in China growth and increased investor risk appetite.

If Greece and Spain – at least for a while – manage to avoid a relapses into sovereign crisis, higher risk appetite will also likely push the Euro and possibly the British Pound higher. Conversely, higher risk appetite together with an expected move towards more aggressive easing by the Bank of Japan following the December general election may contribute to further yen weakness.

Under a scenario of higher global growth and risk appetite the US dollar should also depreciate against most of the world’s major currencies – particularly those in high growth regions such as Asia.

Cautiously optimistic but key risks remain

In summary, while there are a number of serious potential risks that need to be surmounted before the scenario described above becomes a reality, increasing signs of improving global growth and continued strong central bank commitment to highly accommodative monetary policy, indicates that the first part of next year has the potential to be a good one for cyclical and risky assets.

In this environment, commodities could perform well as an asset class, with more growth sensitive commodities such as base metals and the white precious metals having the potential to perform most strongly. Within equities, basic resources and mining companies could outperform. Commodity currencies such as the Australian, New Zealand and Canadian dollars may rise in this environment and, barring a major sovereign debt-related accident, the Euro should benefit. Conversely, funding currencies such as the Japanese yen and the US dollar may come under pressure.

The three key risks to this benign global scenario are a sharp rebound in sovereign risk in Europe – Greece and Spain in particular; the US fiscal cliff issue and possible US sovereign downgrade; and further political and military deterioration in the Middle East. Long gold, oil and volatility positions are potential hedges against these risks.

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